LEVERAGE, HEDGE FUNDS AND RISK
Frank Barbarino, CAIA
Executive Summary
The current market environment has led inves-
tors to reexamine the components of their in-
vestment programs, particularly in light of the
impact of the credit crisis and its accompanying
elevated market volatility. Hedge funds repre-
sent an investment category that has experi-
enced significant challenges, yet we feel they
remain an important component of the invest-
ment structure for many long-term investors1. A
key element when evaluating hedge funds is to
assess the use of borrowed capital, or leverage,
as a part of their investment strategies and the
contribution of leverage to expected return and
risk. This topic is especially important given the
investment climate of late, characterized by con-
strained availability of leverage and higher bor-
rowing costs, and the contribution of leverage to
certain fund blowups in the recent past.
Key takeaways from this paper include:
 Leverage should be an important considera-
tion in the evaluation of hedge fund managers.
While leverage generally amplifies both return
and risk, higher leverage does not always indi-
cate higher risk, as it must be understood in
the context of other features of an investment
strategy.
 We do not believe that it is prudent to use
leverage to magnify the returns of a low-return
position or strategy, or to increase the size of
1
For a general assessment of hedge funds in the current environment please see our recent research note: “Hedge Funds: Broken or Dam-
aged?”
The author would like to thank those individuals at NEPC who provided assistance and encouragement throughout the process of writing this
paper as well as those outside of the firm who provided their insights, with a special thanks to professionals from Robeco Sage.
Consultant, Hedge Funds
the hedge fund balance sheet without having a
great deal of conviction in the underlying in-
vestment ideas.
 There are many ways for funds to obtain lever-
age, each of which offer unique attributes with
respect to term, stability, cost, and availability.
The amount of leverage used by hedge funds
can vary substantially, dictated by the strategy
being utilized and several other variables.
 Analyzing hedge fund balance sheets can help
an investor understand how difficult market
circumstances can affect funds differently,
with some funds able to weather such environ-
ments while others suffer greatly or even go
out of business.
While the hedge fund community’s access to
and use of leverage is evolving, we believe that it
continues to represent a valid tool in the hedge
fund manager’s toolbox and that managers with
better access to it may benefit. Furthermore,
while the use of leverage has in many cases aug-
mented the ability of certain managers and
strategies to generate attractive returns, we do
not believe that in most cases access to leverage
is a prerequisite to alpha generation within the
hedge fund space.
A. How Leverage Works
We define financial leverage as the level of gross
assets greater than equity capital invested. Lev-
Summer 2009
erage allows for the magnification of the return,
and the risk, of the original equity investment.
Leverage exists throughout the economy and fi-
nancial markets. In the case of a company, issuing
additional debt rather than equity has the effect
of amplifying the impact of revenue growth on
EPS. Here are a couple instances of this.
 A bank provides a common example of a com-
pany that issues debt, often representing a mul-
tiple of more than ten times tangible book eq-
uity. Before the current crisis, banks felt confi-
dent doing so because they believed that their
mix of assets had relatively low volatility (more
on this idea later).
 The purchase of a house usually involves lever-
age. An equity investment of, say, $100k (20%)
and a loan of $400k (80%) to buy a $500k
house, represents a four times (“4x”) leveraged
purchase (Debt/Equity).
 Individual investors can also apply the princi-
ples of financial leverage to their investment
portfolios. A margin account allows an investor
to borrow against the value of the securities
and cash held in the account, effectively lever-
aging the return and risk of those securities
100% or 1x (known as the “Reg T” limit).
Let’s look at the math behind how leverage im-
pacts an investment (see Table 1).
B. Leverage in Hedge Funds...The Basics
Hedge funds utilize leverage in a similar fashion to
the way a bank, the buyer of a house, or a stock
investor might. As seen above, leverage clearly
decreases an investor’s margin for error. That is,
when a relatively small amount of capital controls
a large amount of assets, the losses that can be
sustained from those assets before the manager’s
capital becomes impaired can be small. There-
fore, the greater the leverage, the less asset price
volatility the manager will be able to endure. The
incentive structure and competitive environment
of hedge funds sometimes leads managers to
shoot for a high return while ignoring the risk as-
sociated with achieving that return. This is a rea-
son that manager selection in hedge funds, par-
ticularly those who use material levels of leverage,
is so critical.
The past few years are filled with examples of
hedge funds using leverage to amplify the return
of securities with relatively low yields, or trades
with modest expected returns. Indeed, if the re-
turns that are achievable for a manager’s style
decrease, some managers may be tempted to in-
crease leverage to make up the difference. One
example of this phenomenon is that of hedge
funds investing in bank loans throughout 2007
and 2008. Bank loans have historically been rela-
tively stable investments, mainly because they sit

In the case of rising Table 1. The impact of leverage on investment returns

asset prices, one can Asset Prices Rise
see that leverage has a Leverage (Debt/Equity) 1.0x 2.0x
dramatically positive Equity $ 1,000,000 $ 1,000,000
effect on the return on Debt $ 1,000,000 $ 2,000,000
$ 2,000,000 $ 3,000,000
equity (ROE), amplify- Assets
Return on Assets (ROA) 10% 10%
ing a return on assets Gross Profit/Loss (P&L) $ 200,000 $ 300,000
(ROA) of 10% to an Cost of Leverage (at risk-free rate of 2%) $ (20,000) $ (40,000)
ROE of 26% when 2x Net Profit/Loss (P&L) $ 180,000 $ 260,000
leverage (Debt/Equity) Return on Equity (ROE) 18% 26%
is used. However, with
a -10% ROA, 2x lever- Asset Prices Fall
Leverage (Debt/Equity) 1.0x 2.0x
age has a very nega- Equity $ 1,000,000 $ 1,000,000
tive impact, with a - Debt $ 1,000,000 $ 2,000,000
34% result in ROE. Assets $ 2,000,000 $ 3,000,000
These examples illus- Return on Assets (ROA) -10% -10%
Gross Profit/Loss (P&L) $ (200,000) $ (300,000)
trate the importance Cost of Leverage (at risk-free rate of 2%) $ (20,000) $ (40,000)
of handling leverage Net Profit/Loss (P&L) $ (220,000) $ (340,000)
with care. Return on Equity (ROE) -22% -34%

2 Leverage, Hedge Funds and Risk

toward the top of the corporate capital structure
and are secured by assets of the company. They
have historically had low levels of default, and, in
cases in which defaults did occur, high recovery
rates. In recent years these loans traded at very
narrow yield spreads as demand from Collateral-
ized Loan Obligations (or “CLOs”, a leveraged
structure that buys bank loans), hedge funds
(using leverage facilities called total return swaps,
or TRS, more on those later), and other leveraged
market participants bid up prices. The tighter
spreads became, the more leverage was applied
THE PAST FEW YEARS ARE FILLED WITH
EXAMPLES OF HEDGE FUNDS USING
LEVERAGE TO AMPLIFY THE RETURN OF
SECURITIES WITH RELATIVELY LOW
YIELDS, OR TRADES WITH MODEST
EXPECTED RETURNS.
in order to make yields attractive to investors.
The rest of the story is history, as they say, with
investors in CLOs, hedge funds, and other lever-
aged vehicles losing money in bank loans begin-
ning in the summer of 2007 as spreads widened
with more and more market participants attempt-
ing to sell.
We view strategies that are dependent on signifi-
cant leverage in order to generate adequate re-
turns as generally less attractive. This is more
true in today’s environment, because leverage is
not as easy to obtain as it was in the past. Con-
versely, due to the broad selloff of risky assets, in
many cases less leverage is currently needed in
order to obtain attractive returns. Certain hedge
fund strategies do employ moderate leverage,
and many well-implemented strategies can have
good portfolio diversification effects and attrac-
tive risk/return dynamics. Generally, we are com-
fortable if a manager is using leverage in order to
amplify the return of a compelling position or
strategy or if the manager is seeing many high po-
tential return opportunities.
In contrast, however, we feel it is imprudent when
a manager uses leverage in an attempt to magnify
the returns of a weak position or strategy, or
grosses up the balance sheet without having a
3 Leverage, Hedge Funds and Risk
great deal of conviction in his positions. Investor
skill and experience are required in order to dis-
tinguish between these two scenarios.
The level of leverage used by a hedge fund can-
not be observed in isolation as an indicator of the
riskiness of that fund or its underlying strategies.
Understanding the details of each manager’s trad-
ing style, the return drivers of the strategies im-
plemented, and the construction of the portfolio
are essential to the evaluation of a manager’s lev-
erage and risk profile. We attempt to determine
an appropriate leverage level based on the strate-
gies and sub-strategies employed, and based on
our experience of what levels of leverage a man-
ager should be utilizing in their portfolios given
such a strategy.
The “riskiness” of leverage depends on what posi-
tions are being leveraged. When assets that are
expected to move in conjunction instead diverge,
this is a notion called “basis risk”. This is the risk
that two assets behave differently to one another
and lose money at the same time. For example, if
a manager applies leverage to a position consist-
ing of two very similar securities, one long and
one short (e.g. Long Nike stock, Short Reebok
stock), this is much less risky than applying that
same level of leverage to a position consisting of
two dissimilar securities (Long Exxon stock, Short
JetBlue stock). This is because the price of the
similar assets will tend to move in tandem, with
the gains on one offsetting the losses on the
other.
Table 2. Hedge funds and Basis Risk
High Use caution Dangerous
Basis
Risk
Low Acceptable Use caution
Low High
Leverage
[source: NEPC]
A host of fundamental characteristics such as as-
set type, industry, maturity/duration, credit qual-
ity, and the like are useful in understanding the
extent to which long and short positions will be-
have similarly or diverge. Leverage as it relates to
hedge funds is indeed a bit trickier to conceptual-
ize than in the cases of banks or houses since
hedge funds can take both long and short posi-
tions. So, in many cases, leverage may not be a
good indication of the riskiness of a portfolio,
unless it is assessed in the context of other port-
folio and strategy characteristics. High leverage
with low basis risk may be less risky than low lev-
erage with high basis risk. Importantly, strategies
involving less basis risk will tend to call for more
leverage in order to generate returns.
C. Measuring Leverage in Hedge Funds
indicating the multiple represented by the level of
debt above the equity (Debt/Equity).
Some funds use little or no leverage. For instance,
many distressed credit managers currently have
30% or more of their portfolio in cash (though the
existence of cash on the balance sheet does not
necessarily mean that no leverage is employed as
margin financing or derivatives can provide lever-
age without the full use of all available cash). This
is because the opportunities in that space are still
developing. Other strategies do use significant
leverage. Table 3 below provides a sense for lev-
erage levels in various hedge fund strategies.
Indeed, the level of leverage used by hedge fund
managers varies greatly depending on the strat-
egy employed, for example:

There are a number of ways that leverage can be  Merger arbitrage tends to utilize no or little
defined in the context of hedge funds. The first leverage, typically in the range of 1-2x (Long
and most conservative way to measure leverage Market Value/Capital), depending largely on
in hedge funds is to consider the gross value of the spread at which the equities of merger
assets controlled (longs plus shorts), divided by candidates trade in the market.
the total capital (Gross Market Value/Capital).  Fundamental long/short equity also tends to
For example, a fund with $100 million in equity run between 1-2x, with strategies involving
capital with $80 million invested long, and $70 less basis risk tending to utilize higher levels
million invested short for total gross assets of of leverage.
$150 million, would have gross leverage of 1.5x.The  Convertible arbitrage tends to run between 2-
second way to think about leverage, for hedged 6x, utilizing some leverage to magnify the arbi-
or “relative value” strategies in particular (e.g. trage between the convertible bond and eq-
merger arbitrage, convertible arbitrage, capital uity portion of a company’s capital structure.
structure arbitrage), is to look at the value of the
long assets only, divided by the equity capital  Fixed income arbitrage tends to utilize a high
(Long Market Value/Capital). Generally, this is amount of leverage, from 5x to 10x or more
the easiest way to think about leverage and the because the discrepancies being arbitraged
most common way it is expressed. However, one
should always consider
both numbers. The latter Table 3. Typical leverage in hedge fund strategies
method recognizes in- Typical Typical Current
Leverage Guideline (LMV/Capital)
stances where short po- Leverage Maximum Range
sitions serve to decrease Convertible Arbitrage 4x 6x 1-3x
Corporate Credit 1.5x 3x 0.8-2x
risk, that is, they are spe-
Distressed Debt 1x 1.5x 0.3-0.8x
cific hedges for long po- Event-Driven Equity and Merger Arbitrage 1.3x 2x 0.3-1x
sitions or part of a rela- Fixed Income Arbitrage 8x 15x 2.0-10x
tive value position. Global Macro 5x 10x 1-8x
Sometimes, as refer- Long/Short Equity - Fundamental 1.3x 2x 0.3-1x
enced earlier, leverage is Long/Short Equity - Quantitative 2.5x 5x 1.5-5x
Multi-Strategy 3.5x 6x 1-3x
also expressed in terms
of “turns” of leverage,
[source: NEPC, based on data from hedge funds, funds of hedge funds, prime brokers]

4 Leverage, Hedge Funds and Risk

 are very small (LMV/Capital is used since
there is generally considered to be low basis
risk in this arbitrage). This is a good example
of a strategy in which leverage used is not
comparable to other strategies in trying to
ascertain riskiness, due to the low basis risk
and since the underlying securities typically
have lower default probabilities and/or are
highly liquid instruments (sovereigns, agen-
cies, etc). Having said this, certain funds have
had poor performance as a result of basis risk
volatility.
Hedge fund leverage levels have varied signifi-
cantly over time. Generally, levels have dropped
during market turbulence as leverage became
more difficult and costly to obtain. In the current
environment, larger, well-established hedge funds
utilizing a variety of strategies are finding it easier
to obtain somewhat attractive financing terms.
Table 4 below shows aggregate leverage levels
for one of the leading prime brokers on Wall
Street since early 2008. It clearly shows the his-
torical trend mentioned above, with prime broker-
age financing dropping to a low in the post-
Lehman bankruptcy period of Autumn 2008.
While hedge funds are constrained by the financ-
ing environment and must react in accordance
with it, many funds have shown a pattern of pro-
Table 4. Prime broker leverage (Gross market value/Capital)*
* This table refers to gross market value divided by capital. It includes margin financing and some types of swap
financing only. It also does not include financing received by hedge funds from other counterparties.
[source: a large prime broker]
5 Leverage, Hedge Funds and Risk
actively reducing leverage before difficult market
environments transpired and assets lost value.
Said differently, we have observed that many
hedge funds have been effective in varying lever-
age levels throughout the market cycle, utilizing
more leverage when opportunities were plentiful
and valuations attractive, and less when opposite
conditions existed. However, the dynamics of the
most recent cycle, to some extent, beg a question
relating to cause and effect, with the deleveraging
of hedge funds in many cases likely contributing
to price declines across various asset types.
Another wrinkle is how the treatment of deriva-
tive exposure impacts the calculation of hedge
fund leverage. While this issue can be complex,
the basic approach generally used is to
“notionalize” all derivative exposures; meaning
that the dollar value used to express the leverage
associated with the derivative is based on how
much value the derivative controls.
 In a simple case, if one option is purchased
for a premium (cost) of $5 and the option con-
trols 100 shares of a stock trading at $50, then
the value used to calculate leverage would be
$5000 ($50 x 100), not the premium of $5.
The value used would generally be $5000
irrespective of whether the option was, for
example, a call (long) or a put (short), and that
 these options have very different return pro-
files, though in reality they would trade at
slightly different prices.
 Another example is a currency forward con-
tract in which cash flows are exchanged
based on movements in that currency multi-
plied by a theoretical, pre-determined no-
tional dollar amount. In this case the notional
value is generally used in the leverage calcula-
tion.
 Using the notional value of the derivative can
be misleading and may not fully capture the
risk of the derivative, particularly when selling
an option (as opposed to buying one), be-
cause the worst case loss on such a trade can
be large and the payoff profile asymmetric.
For example, if one sells credit default swap
protection (analogous to selling insurance on
the default risk of a corporate entity) and col-
lects a premium, and the company defaults,
the seller has a loss equal to the value of the
security ensured minus the premiums col-
lected. Alternatively, if one buys an option the
downside is generally capped at the premium
paid. In other cases the loss is theoretically
unlimited (e.g. short a call).
 There are other techniques that can, in some
cases, be overlaid on this calculation to try to
account for these limitations, including ac-
counting for the “delta” or sensitivity of an
option to changes in the value of the underly-
ing security (this applies to options in particu-
lar due to their convex payoff profiles).
D. How Hedge Funds Obtain Leverage
Our hedge fund manager due diligence not only
looks at the level of leverage used, but also, im-
portantly, its source and nature. These details are
critical, since the sudden withdrawal of financing
can force liquidation of positions, generally at the
least opportune time. It is also important to un-
derstand how much total leverage is at the dis-
posal of the manager, to get a handle on how
much “gas” the manager can apply to the portfo-
lio. Let’s look at some of the methods and instru-
ments hedge funds use to obtain leverage.
 Prime brokerage: The simplest and most
6 Leverage, Hedge Funds and Risk
common source of hedge fund financing is
borrowing from a prime broker who provides
a form of margin financing, generally at either
the position or portfolio level. Prime broker-
age financing is generally easy to obtain but
financing terms can be changed on short no-
tice. Prime brokerage financing is also typi-
cally of short duration, resulting in a potential
mismatch between the duration of the firm’s
assets (take longer to liquidate) and liabilities
(can be called quickly). In order to mitigate
this risk, hedge funds often seek to add “term
structure” to their prime brokerage margin
facilities. If a fund has, for example, a 90 day
notice built into their agreement with a prime
broker, this keeps the prime broker from cut-
ting financing on a position or terminating a
relationship with a fund altogether on short
notice and most likely at the worst possible
time. This is a significant concern for hedge
funds using leverage. In the current environ-
ment, not all hedge funds have been able to
add term financing to their balance sheet, and
prime brokers are being very selective about
extending credit. Better treatment accrues to
larger, more established funds with steady
returns, diverse assets and strategies, and
locked-up equity capital.
When a security is borrowed from a broker
and sold short, a hedge fund receives cash
proceeds from the sale, on which it is paid
interest at prevailing rates (there is also a cost
associated with borrowing the security that is
a function of how difficult the security is to
obtain, known as the cost of borrow, with the
difference between the two known as the
short sale rebate). Certain prime brokerage
arrangements allow the borrower to reinvest
these proceeds to purchase additional securi-
ties long. Prime brokerage is limited in terms
of the level of leverage it can provide (though
certain forms of prime brokerage financing
allow leverage to exceed Reg T limits), thus
banks and hedge funds have over the years
developed creative structures to provide
greater levels of borrowing.
 Repurchase agreements (aka “repo”): An-
other source of hedge fund financing, particu-
larly for those trading fixed income instru-
 ments, is repurchase agreements, or repos. In
a repo transaction, a hedge fund typically de-
livers a security that it owns to a lender as
collateral in exchange for a loan. Repo trans-
actions are generally of a fixed, short term
nature ranging from one night to one month.
With the perception of counterparty risk cur-
rently at relative high levels, though, most
repo transactions are of the overnight variety,
limiting their value in the current environ-
ment.
IT IS ALSO IMPORTANT TO UNDERSTAND
HOW MUCH TOTAL LEVERAGE IS AT THE
DISPOSAL OF THE MANAGER, TO GET A
HANDLE ON HOW MUCH “GAS” THE
MANAGER CAN APPLY TO THE
PORTFOLIO.
 Total return swaps (“TRS”): Hedge funds
can also obtain financing through TRS facili-
ties with banks. A TRS allows a hedge fund to
receive the leveraged ‘total return’ of an un-
derlying asset or pool of assets. Bank loans
and equities have historically been the most
common security financed through TRS. TRS
transactions are typically structured in such a
way that is tailored to the specifics of the un-
derlying asset pool. TRS facilities in place
around banks loans and other types of collat-
eral can be an attractive source of term fi-
nancing, though many of these have safe-
guards in place that allow the bank to take
away the financing if, for example, the market
value of the collateral were to deteriorate.
 Secured credit line: A secured line of credit,
though difficult to obtain at fair financing
rates in the current environment, is another
source of financing for hedge funds. This is
typically structured as a committed revolving
line of credit that is renewable on a periodic
basis supported by certain assets held in the
fund. A hedge fund who has obtained this
source of financing has an advantage in the
marketplace today as it allows them to pur-
chase assets with a longer duration with little
7 Leverage, Hedge Funds and Risk
fear of being forced to sell at the wrong time,
though banks have in a few cases found ways
to back out of these financing lines.
 Structured financing vehicles: The most so-
phisticated hedge fund managers were able
to structure transactions to provide longer
term financing for their portfolios. These vehi-
cles, structurally similar to CLOs or CDOs,
were a creation of the leveraged economy,
and are difficult to issue in the current envi-
ronment, since few investors are willing to
purchase their debt. Those funds that created
these structures and purchased portfolio as-
sets with the proceeds have a long term, sta-
ble, cheap form of financing for their portfo-
lios.
 Derivatives: Derivatives of all kinds, including
options, futures, and forward contracts, con-
tain implicit leverage. As discussed above,
utilizing a relatively small amount of margin,
these contracts allow the investor to “control”
a much larger level of notional assets. This is
slightly different in the sense that derivatives
allow for leverage without the fund having to
actually borrow money to finance their posi-
tions (off balance sheet).
E. Hedge Funds and Leverage...What Can Go
Wrong?
We have addressed how hedge funds apply lever-
age, how investors can measure it, and how lever-
age is obtained. Let us now tie this all together in
an attempt to understand the practical risks of
leverage in hedge funds. It is critical to recognize
in what circumstances leverage can be an appro-
priate tool used to generate attractive returns
and, on the flipside, how leverage can interact
with and feed on other risks, becoming quite dan-
gerous. To do so, we will look at some real world
examples.
To understand what can go wrong, we must first
look at a typical leveraged hedge fund balance
sheet (see next page).
On the right hand side of the balance sheet we
have the liabilities, known as the “capital struc-
ture” of the fund. In light blue, we have the inves-
tor capital, or equity. At the top, in darker blue,
are the financing sources, or debt. This financing
could take the form of prime brokerage margin, a
secured credit line or other credit facility, as dis-
cussed earlier. In addition, the right side of the
balance sheet includes shorted securities, since
these are borrowed and then sold, representing a
liability. In many cases, the cash obtained from
the sale can then be used to purchase additional
securities long. Derivatives, in orange, can be ei-
ther an asset or a liability, depending on whether
the fund is long or short the derivative. In a case
in which the fund is selling credit default swap
protection, for example, this would be a contin-
gent liability of the fund (though in this example
the liability moves to zero if default does not oc-
cur). In some cases, the notional value of deriva-
tives can be of significant size relative to the over-
all size of the fund balance sheet.
Table 5. The hedge fund balance sheet
Assets Liabilities
Free Cash
Financing Sources
Margin (Debt)
Securities Investor Capital
(Equity)
Derivatives (Off balance sheet exposures)
[source: NEPC]
On the left side of the balance sheet, the asset
side, the largest blue box is represented by the
securities held by the fund. Note that this box is
larger than the light blue box on the right side
representing investor capital; this indicates that
the fund is using leverage, otherwise it would only
be able to purchase securities up to the value of
the equity provided by its investors. As men-
tioned, derivatives can represent either an asset
or a liability on a fund’s balance sheet. In a case in
which the fund is buying protection on CDS, this
would be considered an asset of the fund (though
the asset value moves to zero if default does not
occur). We also have cash and margin. Margin is
8 Leverage, Hedge Funds and Risk
the collateral or “haircut” required by a lender in
order to extend credit. It provides a buffer for
volatility in the assets being leveraged. If the
volatility or the probability of loss in these assets
is high, larger margin levels will be required. For
example, a portfolio of government bonds will
require much less margin than one of high yield
bonds. Hedge funds are currently making every
attempt to maintain the least amount of margin
with their lenders in order to minimize counter-
party risk. This brings us to the last piece of the
asset side of the balance sheet, which is cash.
Depending on the strategy, most funds will be
able to hold some level of cash on their balance
sheet. Hedge funds have also been careful as of
late in terms of where and with whom cash is
held, again in order to minimize counterparty risk.
An asset-liability mismatch is one of the most seri-
ous problems that can occur with a hedge fund,
most notably in the context of liquidity and/or
duration. Most often this mismatch is coupled
with an increase in volatility and correlation in the
market. 2008 was a year that saw many examples
of this phenomenon.
Let’s look at two funds, Fund A and Fund B. Here
are the basic attributes of each fund:
Fund A
 Invests in diversified long and short portfolio
of 60-80 large cap equities, roughly balanced
but with a modest long bias
 Portfolio is financed through prime broker
margin
 Has $100m in equity capital from 10 pension
funds with long investment time horizons
 Redemption terms are quarterly with 90 days
required notice before the redemption date
 Leverage is low at 1.3x (LMV/Capital), the
fund has gross long assets of $130m
 The fund is 130% long and 100% short
 10% of the fund’s NAV is in cash
Fund B
 Invests in a concentrated credit strategy with
 20 long stressed and distressed bond posi-
tions and 10 short positions, including some
equity index shorts and some corporate
credit index (CDX) buy protection
 Cash positions are financed with prime bro-
ker margin and derivatives are used
 Has $100m in equity capital from two funds of
hedge funds
 The two fund of funds who invest in Fund B
obtained their capital from several Swiss den-
tists
 Redemption terms are monthly with 30 days
required notice before the redemption date
 Leverage is moderate at 3x (LMV/Capital),
the fund has gross long assets of $300m
 The fund is 300% long and 250% short
 10% of the fund’s NAV is in cash
Now let’s put each fund through a perfect storm,
much like the one witnessed in the fall of 2008,
with the following basic parameters:
 Equity and bond markets sell off materially
 Market volatility spikes
 Correlation amongst similar securities spikes
 Typically less liquid securities become impos-
sibly illiquid, with no bids
 Idiosyncratic risk increases
 Default probability increases
 Investors, particularly Swiss dentists, become
very skittish and move to cash (cash is king!)
Which fund is most likely to be able to survive this
type of market? Fund A is diversified, trades liq-
uid securities, uses little leverage, and appears to
have a stable capital base. Fund B is quite differ-
ent. First, the latter fund is concentrated with
only 20 longs and 10 shorts. With $300 million
invested across only 20 long positions, the aver-
age position size is $15 million, or 15% of NAV
(equity capital). Secondly, the fund has significant
basis risk between its long and short positions.
9 Leverage, Hedge Funds and Risk
This is a problem in that the long and short books
may behave very differently. Conceivably, over
any particular period, the fund could, for example,
lose money on its longs and also lose money on its
shorts. Thirdly, the fund’s 3x leverage is obtained
through prime broker margin and repo without
built-in term structure Given the nature of the
assets, less liquid distressed securities, it is ques-
tionable as to whether a prime broker would in
the current environment provide financing up to
3x, but let’s say this is possible for the sake of ar-
gument.
Here is how things might unfold:
Fund A
 The perfect storm hits but the fund remains
flexible; it can reduce, add, or eliminate posi-
tions. The fund suffers idiosyncratic events in
3 positions that are down between 30% and
50%. The fund eliminates two of these and
adds to one. The vast majority of the fund’s
long and short positions are financed with
cash. Most of the positions financed with mar-
gin turn out to be some of the less volatile
positions in the portfolio; the fund receives
margin calls on a few of these positions but
easily meets these with cash from other posi-
tions it sold.
 The investors of the fund are concerned, but
the manager is able to explain that it sees the
current market conditions as a temporary ab-
erration, that the fund remains very nimble,
and that most of the losses are mark to mar-
ket only and not realized. Most investors
seem to be on board, with only 8% of fund
capital requesting withdrawal for next quar-
ter.
 The fund is hurt on the long portfolio but the
short portfolio moves up, as expected. The
fund loses 4% over the course of a month,
down -12% on its longs and gaining +8% on its
shorts.
 Though the fund performed poorly during the
storm, it will live to fight another day, and may
even be in a position to pick up some bargains
in the beaten up market. Its financing provid-
ers are comfortable with the current portfolio
 and continue to extend credit to the fund. from financing providers and investors look-
Investors are not happy about losing money, ing to redeem, the fund has no flexibility to
but still believe in the fund. hold its slumping positions, much less buy into
opportunities. The prime broker is loathe to
Fund B continue to finance the fund and, although
 The fund is in a dire situation. It suffers idio- leverage is now down to 1.5x (LMV/Capital),
syncratic events in 6 positions that are down this number may be forced down further, es-
between 30% and 60%. The fund receives pecially if markets don’t turn around. The
margin calls on these and other positions. It prime broker is also watching to see how the
uses cash on hand to meet a few margin calls redemption situation of the fund evolves, and
and attempts to sell some of its more liquid most likely will shortly pull all of the fund’s
positions to meet the others, but in the mar- financing.
ket’s flight to quality there is a lack of bids for Table 6. Factors that determine appropriate hedge
their positions and prices gap down. The fund leverage levels
fund lacks flexibility and is forced to sell posi- Leverage Level
tions at fire sale prices, even though it be- High Moderate Low
lieves these will ultimately recover, in order High
Asset credit
to meet margin calls. Some securities are im- Moderate
quality/price
possible to sell as there are absolutely no Low
bids. High
Asset duration Moderate
 To make matters worse, the fund’s investors Low
have learned of the fund’s woes and have
asked the manager to return 50% of the High
Asset liquidity Moderate
fund’s capital before the 30 day redemption
Low
deadline expires. These funds of funds have
their own pressures, as the Swiss dentists High
Asset price
have lost confidence in them and are asking Moderate
correlations
for their capital back. In a panic to raise addi- Low
tional capital, the manager continues to sell High
Asset price
positions, realizing significant additional Moderate
discovery
losses. Low

 The storm causes many of the fund’s longs to High

Asset volatility Moderate
gyrate wildly, losing a great deal of value,
Low
while other positions show little price discov-
ery and liquidity and prices appear to fluctu- High
Portfolio basis
ate less. Generally, the fund’s positions are Moderate
risk
much more volatile than the manager antici- Low
pated. In the end, the short book does fairly High
Position
well, but unfortunately gains much less than Moderate
concentration
what is lost on the long side. Within 4 weeks, Low
the fund has lost 18% of its value, losing 25% High
on the long side and gaining only 7% on the Stability of
Moderate
capital base
short side. Low

 The fund’s future is uncertain and it may be High

Term of
doomed. The fund has lost 18% of its value financing base Moderate
Low
because it applied significant leverage to a
{source: NEPC]
risky, illiquid space and its portfolio had mate-
Green = Acceptable
rial imbedded basis risk. Due to pressure Yellow = Use caution
Red = Dangerous

10 Leverage, Hedge Funds and Risk

 The table on the previous page summarizes a list dress these complex topics directly with manag-
of key factors that dictate the appropriateness of ers. Hedge fund managers, for their part, are re-
the leverage level used, coupled with examples alizing that it is also in their best interest to be
where various factors are combined to create sure that investors fully understand these risks,
differing scenarios. Many hedge funds have lost and that both sides should not focus solely on the
material amounts or even all of their value by ap- reward side of the equation.
plying leverage to particular assets or a portfolio
of assets in an inappropriate manner, such as in
the “dangerous” scenario above (for instance, in
the case of hedge funds run by Bear Stearns).
Excessive growth of the capital base is also dan-
gerous as it creates a situation where the man-
ager must deploy assets, potentially growing the
balance sheet using lower conviction ideas. In
each case, the combination of factors causing the
crisis has been unique. Finally, and perhaps most
importantly, manager hubris has almost always
been a factor in the demise of hedge funds.
There is no doubt that the human element is a
critical piece of analyzing hedge fund risk, making
qualitative analysis, such as understanding the
incentives of the investment professionals run-
ning a hedge fund, as important as understanding
the quantitative aspects.

F. Conclusion

Hedge funds will continue to use leverage to en-

hance their alpha generation capabilities, and
while we do not believe that leverage is a require-
ment, we do think that those funds that can ob-
tain and use it appropriately may have a competi-
tive advantage going forward. Indeed, recent
market turbulence highlights the importance of
focusing on high quality hedge fund firms that
have developed well-structured, robust invest-
ment processes to address both investment risk
and operational risks that can easily translate into
investment risk, all while achieving their invest-
ment objective through a variety of market envi-
ronments.

For many of these managers, leverage will remain

an important tool for achieving their return goals.
Now more than ever, investors must take a pru-
dent and thoughtful approach to assessing not
just leverage, but a variety of risks imbedded in
hedge funds, and they must be prepared to ad-

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